Sunday, October 16, 2016
Creating a Budget: The 50/30/20 Budget System
Now that you have an idea where your money is going, we can zoom in on this a little. I want to introduce you to the 50/30/20 Budgeting Guideline (initially made popular by Elizabeth Warren). If you type it into a search engine, you will get a zillion hits. It is basically a guideline that helps you to determine how much of your income should be going where. Different financial writers will describe them slightly differently, but here is my version: 50% of your take-home pay should go to fixed expenses, 30% goes to flexible (or lifestyle) expenses, and %20 should go toward goals.
50% Fixed Expenses
Let’s look at the first category. This is the 50% category, and it is devoted to fixed expenses that are needs only. There should not be any wants in this category. These are the things that you literally must have to function, and they cost you the exact same thing every month. Your rent/mortgage payment, the cost of your transportation to and from work, certain utilities, etc. I put only a handful of things in this category because there are very few things that are fixed cost needs. Quite frankly, I even put groceries in another category, because while I need food, I can scale back on certain items to impact the dollar amount I spend. I do not have that kind of choice where my mortgage, rent, car insurance, car payment, or public transit pass are concerned. Those items cost me the same thing every month, I can do literally nothing (short of moving, selling a car, etc.) to alter the cost, and I absolutely must have this in order to function in my day to day life. Once you have figured out which of your subcategories (mortgage/rent, car insurance, etc.) go into the 50% Fixed Expense category, you need to do a little math. If you take home $3000 each month after taxes, then this category should take up no more than $1500 per month. If you are spending more than 50% of your take-home income in this category, you may need to face some tough choices in order to get these numbers down. You may need less expensive transportation or housing. Alternately, you could consider a roommate or an extra job. You maybe wondering why it matters whether or not you go above 50%, especially when these expenses are the most fundamental to your life. It’s a fair question. If you are spending so much money in this category that it goes above 50%, you won’t be able to pay down your debts or save for your future. If you are unable to do those things, you will risk putting yourself in an unstable position when you are in your golden years. If you are struggling to make ends meet now, when you are theoretically in the best health and with the most energy to work, how do you think you will get along when you are significantly older?
30% Flexible or Lifestyle Expenses
The next category is for Flexible or Lifestyle Expenses. This should be no more than 30% of your after-tax monthly pay. These could be one of two things: a regular monthly bill that could be trimmed back if you needed to or has a changing payment amount, or things that you spend money on for recreation of some sort. There are a few things that are in this category that appear to be REALLY important, so important in fact that you may wonder why they weren’t in your 50% category. Let’s take a look at a few. The first item is groceries. You MUST have food to live, but this expense is flexible. If you fall on hard times, you may qualify for the food stamp program which will alleviate you of some of these expenses. You also have a huge range of choices regarding what to buy and how much it will cost you. Perhaps dining out is a huge priority with regards to lifestyle. That number also shows up in this category. Another surprising item that is in this category is your cell phone bill. You need telephone access now days, but let’s be honest. You probably do not have the cheapest most basic plan available right? Well neither do I, and that’s fine. It is a lifestyle choice, and if push came to shove, and you could scale back that expense as needed. Another expense that is very important, but flexible is your student loan debt. It is very important that you pay on these debts, but the payments are flexible. If you became ill or unemployed and your student loans are federal, you can have your payments reduced or deferred. A credit card payment is also a flexible expense. As your balance goes up or down, your payment amount will change. If you became ill or unemployed, these debts could be discharged in a bankruptcy (not ideal, but possible). Other items that are flexible, lifestyle expenses are entertainment, dining out, clothing, and many others. The basic rule of thumb is that if you could reduce the payment or eliminate some or all of the expense, then it is in this category. Note about student loans and credit cards. Only the minimum payment amount belongs in this category. Once you have determined how much money you are spending in this category, compare it to 30% of your take-home income. If you are spending too much in this category, you can easily fix it. Decide where you can scale back so that you are comfortable within that limit. If you are already below 30% in that category, even better. You have more funds to allot to goals.
That brings us to the final 20%. This is for goals. This is the category that makes me feel excited because I feel like this category is directly related to my own financial freedom and future. If you earn $3000 per month after taxes are taken out, then 20% is $600. That is the amount you can spend on goals. Goals should be a combination of savings and paying down your debt. These are both super important, and you should be doing both. If you have money left over from another category, I recommend that you give it a home in the “goals” category. Paying down your debt will free up some of your income for other things. In terms of savings, you should have at least two different types: retirement savings and emergency savings.
If you are using some kind of software to help you with this budgeting, it will easily figure these numbers for you. If you are using pen and paper, just calculate how much is 20%, 30%, and 50% of your income, and track it. Each month you will be able to see whether you are within the parameters you have set for yourself and adjust your spending as needed so that you can make progress toward your goals.